Erratic Start to the Next Growth Cycle

Construction spending will expand 3.4 percent this year, up only marginally from 2.7 percent in 2003.

By Jim Haughey, Director of Economics

January 01, 2004

Strong GDP growth was restarted last May by a second round of cuts in income taxes and credit costs. Now growth is self-sustaining due to recent gains in employment, investment and exports. Economic growth from mid-2003 through 2004 will average above the long-term sustainable pace of near 4 percent as idle labor and capital are put back to work. Economic growth should continue near 4 percent in 2005 without generating significant inflation because not all of the idle resources will have been re-absorbed by the end of next year.Business investment has been rising for three quarters, driven by parallel gains in corporate profits and business confidence about future demand growth. This will continue at nearly a 10-percent pace through next year. Initially, the added investment is mostly for machinery, but growth in structures investment will progressively catch up over the next year.Interest-rate trends are now up, but slowly. Both mortgage rates and the prime rates typically used for construction loans will remain historically low next year. Little change is expected for either rate until the Federal Reserve Board switches from monetary stimulation to restraint by raising credit costs. this is possible in the spring. Credit standards will be eased in an expanding economy, cutting credit costs for some marginal borrowers.Housing starts peaked in late 2003 at nearly 1.9 million units and are now subsiding to a 1.7-million-plus pace for the next two years. Together with manufactured homes, this is the underlying demographic demand for additional housing. About 1.7 million starts is the minimum in a rapidly growing economy. It could be more with high immigration or with a delay in raising credit costs because of high labor productivity that restrains inflation.The residential share of construction, including remodeling, soared to 51.8 percent in 2003 but is expected to drop to 50.5% in 2004 and then dip further in 2005. The heavy-sector share will rise 0.3 percentage points to 18.5 percent, and the nonresidential share will increase a full percentage point to 31 percent.

Construction spending will expand 3.4 percent this year, up only marginally from 2.7 percent in 2003. The construction cycle bottomed in 2002–03, and 2004 will be the first year of a multiyear growth cycle. Both the mix of projects and the trend over the year will be much different than last year.

The residential sector hit an exaggerated peak late last year, slightly more than offsetting the declines in other sectors that continued well into the year. Spending on new residential projects will begin strong in 2004, but decline slightly over the year; nonresidential and heavy activity will start the year at depressed levels and progressively improve.

The economic environment begins the year fair to good for private nonresidential and heavy projects and will improve over the year. Excess capacity will be shrinking, modest corporate profits will be expanding, business confidence is good and improving, credit costs (after inflation) are below average and will tighten only slightly, and money is flowing to real estate from the depressed bond market.

Yet the economic environment in the public sector begins the year depressed—still stuck in the last recession. Although it is expected to improve during the year, it will not catch up to the private sector until 2005.

The flow of additional money to public construction will be lumpy because it depends on the timing of political actions, such as permanent renewal of the federal-highway-funding program, passage of bond issues and legislation, and the next round of state budgets. Some project types and regions will see an injection of money before others. We expect fiscal year 2004–05 budgets that begin on July 1 or Oct. 1 to include significant gains in construction funding. This may be delayed a year in California and other states with the most serious deficit problems.

The consensus forecast for growth in gross domestic product this year is about 4 percent. Canadian and Mexican economic growth will also pick up to this level, adding to demand pressures in the United States. Manufacturing and exports will grow faster than the rest of the economy after a three-year slump. This pace will take much of the current slack out of labor, credit, equipment and materials markets, but not enough to cause significant supply problems in the construction market. But tight supply problems will likely develop later in 2005.

Expect the biggest growth turnaround in regional economies dependent on durable goods manufacturing, healthcare and medical supplies, and handling foreign trade with Asia. This includes New Jersey, Los Angeles and the Buffalo- Milwaukee corridor. Other hot spots may be the grain belt (prices have soared) and near military bases as the troops return.

But the national economic surge will have much less impact—especially early in the year—on regions dependent on public employment, education, packaged goods manufacturing, finance and business services. This includes New York, Atlanta, Boston, Washington, Miami and San Francisco.

Source: U.S. Commerce Dept.Estimate and Forecast: Reed Research GroupSpending on nonresidential projects has been rising since last spring, but has so far only recovered about one-quarter of the decline from the peak of the last spending cycle. Continued expansion will recover three-quarters of the decline by the end of 2004. Total nonresidential spending will increase 6.4 percent this year. The gains will be primarily in the cyclical and mostly private office, lodging, commercial (retail) and manufacturing markets. Their expansion follows directly from the improving economy, but the timing of their return to growth, except for commercial, is still a forecast and could slip later.

Heavy Construction Trends & Outlook

$ Bilions

Annual % Change

2004

2002

2003

2004

Total Heavy Construction

168.5

4.9

-2.6

4.6

Highways & Streets

61.6

3.0

-1.7

2.9

Power

35.9

7.7

-5.0

3.6

Transportation

25.4

8.5

-1.9

4.5

Communication

17.8

-7.3

-11.4

10.2

Water & Sewer

23.6

14.2

4.8

5.8

Conversation & Development

4.2

n.a

2.0

8.0

Source: U.S. Commerce Dept.Estimate and Forecast: Reed Research Group

Heavy-construction spending will rise 4.6 percent in 2004 and is expected to be increasing at a 6- to 7-percent pace by the end of the year. Yet real growth after inflation over the 2002–04 period will be only 1 to 2 percent, a little better than the small decline in the last post-recession weak market of 1994–96. Heavy project activity depends on capacity needs, tax receipts, business and consumer confidence and corporate profits. All have been subpar over this period. All are now rising, but did not rise enough to begin spurring significant commitments for new capacity or renovations until the end of 2003.

Construction Spending to Increase 3.3% to $919.8 Bilion

$Bilions

Annual % Change

2004

2002

2003

2004

Total Construction Spending

$919.8

2.3%

3.4%

3.3%

Residential, New

$337.1

7.2%

11.3%

-0.4%

Residential, Improvements

$130.7

12.6%

1.0%

5.1%

Nonresidential

$282.6

-7.6%

-1.5%

6.7%

Nonbuilding

$169.5

4.9%

-1.4%

3.8%

Total Private Construction Spending

$698.7

-0.2%

3.6%

3.3%

Total Public Construction Spending

$223.4

11.1%

2.9%

3.6%

Source: U.S. Commerce Dept.Estimate and Forecast: Reed Research Group

Total construction spending will be 3.3 percent higher in 2004. After inflation, real growth will be about 1.5 percent. The pace of growth begins the year low and improves steadily. Inflation-adjusted spending growth is expected to be barely above zero until summer when business-space needs begin to increase quickly and a new, less-constrained, fiscal year begins for public budgets. So far only the healthcare and commercial markets are expanding consistently. Growth will accelerate to a rate of 2 to 2.5 percent in the second half of 2004 and rise further in 2005.